Mutual funds get a tough report card

Commentary: Morningstar’s new fund-rating system is a game changer

CHICAGO (MarketWatch) — Morningstar Inc., the investment research firm, is about to answer mutual fund investors’ biggest question — and drop a bomb on the fund business in the process.

After years of rating funds on past performance, Morningstar
MORN
intends to tell investors which funds it expects will do best in the future.

The addition to the Chicago-based firm’s rating system, announced at the Morningstar Investor Conference here on Thursday, will shake up the fund world and forever change the way investors evaluate mutual funds.

To see why, let’s look at what Morningstar currently offers and what’s coming down the pike.

Morningstar is best known for its star ratings, which objectively measure funds against their peers based on risk-adjusted returns. Stars are given on a curve, so the top 10% of a category get five stars, the next 22% earn four stars, the middle 36% receive three stars, and so on.

But the star system has limitations, which Morningstar has always acknowledged, saying that stars are more descriptive than predictive. Because it looks at past performance — and only for funds with track records of at least three years — setting your financial course by the stars is akin to driving while looking in the rear-view mirror.

Morningstar has never suggested that stars were investment recommendations. Yet many investors have acted otherwise. Industry statistics show that $9 of every $10 that goes into funds flows into issues that carry at least four stars.

What Morningstar announced this week is dramatically different, a subjective measure that tries to predict which funds will do well in the future — effectively something that truly qualifies as a purchase recommendation.

In addition to the traditional star rating, Morningstar this fall will give funds an “analyst rating” based on five key criteria to determine if they have a positive, neutral or negative outlook. A year from now, Morningstar expects to have analyst ratings on more than 1,500 funds, covering more than 80% of all industry assets.

Analyst ratings will replace Morningstar’s “analyst picks” and ‘analyst pans.” They will be more extensive and will be displayed even more prominently than star ratings.

There are three gradations for “positive” analyst ratings. AAA-rated funds are “best of breed,” while AA-rated funds have “notable advantages across several areas” and funds with an A grade have “advantages that outweigh disadvantages” in the five key areas that Morningstar believes predict future success for a fund.

Those “Five Pillars” feature qualities that institutions frequently use in their investment decisions. These include: process (investment strategy and execution), performance (results versus expectations over time); price (expense ratios); people (management’s skill, plus its conviction and dedication to the fund), and parent (stewardship grades, a Morningstar measure of the quality of governance).

Morningstar’s research has shown that combining star ratings with low costs and high stewardship grades typically leads to positive performance in the future. Analyst’s ratings put those criteria and more together in one grade.

There is no curve to this grade. Don Phillips, Morningstar’s president of fund research, said that roughly 3% of all funds have earned the “analyst’s pick” designation, and he expects that to be around the top percentage of the positive grades. All told, Phillips said somewhere between 10% and 20% of all funds are likely to earn positive ratings. The rest will be “neutral” or “negative.”

Stars and high bars

Here’s where the game changes for investors.

Investors who trust Morningstar will want funds that have the best of both worlds — a positive analyst score plus a quality star rating.

Using Phillips’ math, however, the pool of positively rated funds will be around half the size of the current pool of four- and five-star funds (it’s possible for funds with fewer stars to earn a good analyst grade).

Thus, a four-star fund that gets a neutral rating will no longer be impressive. In fact, when I asked investors at the conference about it, people said they’d avoid funds that didn’t get both four- or five-stars and a positive rating. That will undoubtedly be true for the people running retirement plans, too, since they have to convince customers they’re offering the best funds.

Expect a rush of money to funds earning top marks in both ratings. And Morningstar also will give analyst ratings to funds that aren’t yet old enough for stars, a particularly strong, buy-it-out-of-the-box statement.

“We hope this improves investor returns, helping them pick funds they can believe in for the future,” Phillips said, “so that people won’t run out of a fund that is simply out of favor. … Our research shows that being patient with good funds should pay off, but you have to believe they will bounce back, which our analysts will on positive grades.

“And the mediocre funds that are impacting investors ability to reach their goals? We hope they get found out too,” Phillips added, “so that investors know to go somewhere else.”

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